Improve Cash Flow By Paying Off Low Interest Debts

Quite often, when I write answers to reader mailbag questions, I encourage people to keep pushing hard against their debts no matter the interest rate. Almost everyone agrees that it makes sense to rapidly pay off the 15% debts, but I’ll often get a lot of disagreement about the 3% debts. People will often ask why they should hurry to pay off a 3% debt. After all, they can get a better return in other investments.

The reason is simple. It’s all about the cash flow.

What is Cash Flow?

Let’s start off with the basics and explain what cash flow is. Cash flow refers to the amount of income you take in minus the required bills you have to pay. Ideally, you have money left over at the end of this process, and the more cash you have left over, the better. That cash can be saved for the future, invested, or applied to extra debt payments.

Let’s say, for example, that you’re bringing home $3,500 a month. You have a $1,000 mortgage at 6.75%, a $500 student loan payment at 3%, and another $1,000 in required bills (electricity, food, fuel, etc.). At this point, you must have $2,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $1,000 to do with what you please.

Now, let’s look at your situation if the mortgage is paid off. You still has a $500 student loan payment and another $1,000 in required bills. You must have $1,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $2,000 to do with what you please.

Because your mortgage is paid off, your monthly cash flow is far better than before. This helps you in countless ways.

Let’s say you lose your job and can only find one that gives you a 40% pay cut. At this point, you’re bringing home only $2,300 a month. In the first scenario, you have $2,500 in required bills. You’re going to have to make some major scary cuts in your life in order to make ends meet. In the second scenario, you have only $1,500 in required bills. You’ll be just fine and still have a surplus.

There are countless other examples of life changes, planned or otherwise, that can significantly alter your income. The greater the amount of required bills each month, the more difficult it is to swallow those life changes.

This is why it’s nearly always useful to improve your cash flow. Improving your cash flow improves your life options. It makes job transitions far less painful, for one. When you’re fired or “downsized,” you can take a lower paying job without pain. On the other hand, you also have a lot more flexibility with your career choices as you’re able to take a lower-paying but more career-building job. In fact, this is exactly what I did: I paid off a lot of debts, which reduced my monthly required payments and made it easier for me to live on less income, which enabled me to switch to writing The Simple Dollar full time because my cash flow was in much better shape.

The worse your cash flow situation is, the more you’re tied to your current job. It gives your boss more power and you less power because the threat of losing your job is devastating. Your job becomes more stressful by default because the always-present threat of losing that job – and the pain it would cause – is always hanging over your head. Your career options are limited, too, because you can’t deal with a reduction in pay.

In short, pinching your cash flow pinches your options.

Debt pinches your cash flow, of course. For example, getting a car loan pinches your cash flow because you’re now responsible for those payments. On the other hand, living without a car loan for a while and saving up for your next car is a much better cash flow option, as it allows you to simply pay cash for the next car, keeping your cash flow as wide as possible.

Overspending pinches your cash flow, too. If you needlessly spend a lot of money, you’ve pinched your cash flow for that month. You take money away from your savings. Thus, at a later point when you need that cash for a purchase, you’re forced to rely on debt, which forcibly pinches your cash flow.

It’s because of these things that I usually encourage people to just get rid of all of their debt. Eliminating all of your debt opens that cash flow up, making it easy to save for the future, change to a different job, or make other significant life changes that would be nearly impossible with a constant debt payment hanging around your neck.

Whether this is true for all debt, it is wrong for low-interest student loans, which 1) can be put in forbearance if you have a job loss and 2) will be forgiven in the event of your death.

I’d say, with any low-interest debt, just put away the extra money you’d be paying into an account with a reasonably good interest rate that isn’t scary-risky. You could always pull it out to pay off the low interest debt if you needed to for some reason.

Sure, with an investment there’s a chance you’ll lose some of the cash, but as long as you don’t need to pull it out super-fast, there’s a far better chance you’ll profit on a higher interest rate and it’s highly unlikely your investment will be completely depleted. Overall, this advice is only good for the super-duper conservative who would lose sleep over these small possibilities.

First is that you’re not considering what else you might be doing with the money if you’re not paying down the debt. If it’s a choice between paying down the debt or flushing the money down the toilet, then sure, I agree that it’s better for you to pay down the debt. But if, instead, you put the extra money into savings – even if the interest you earn on the savings is less than the interest you’re paying on the debt – then you’re in a position that’s almost as good net-worth-wise, and much better flexibility-wise, than if you’d paid down the debt. You can always take money out of savings to pay down the debt later, but you can’t (usually) undo the extra debt payments if you find you need the money for something else.

Second, you don’t get the full cash-flow benefit of paying off the debt until you pay it off entirely. (And if you don’t have the option of “recasting” the loan to give you a lower monthly payment, you don’t get a cash-flow benefit at all.) And layoffs, pay cuts, and other emergencies aren’t going to wait patiently until you finish paying off your mortgage.

I totally agree with you on this one. When I paid off my credit cards and refinanced my car into a really low interest rate loan, I struggled with what to do with my surplus income every month. It seemed stupid to pay off my remaining debts (which were all really low interest) but it was still a stretch to be saving every month as much as I really wanted to be because my income was so tied up with payments.

Eventually I decided to pay off my private student loan and my car to free up A LOT of money every month, and I’m happy with the decision. Pretty soon I’ll be socking tons of money away every month, because of the better cash flow I’m getting from paying off the low-interest loans.

+1 for #3.
Trent,
You missed the boat on the cashflow piece.
You don’t get the benefit of added cashflow if the debt is not fully retired.

Furthermore, you have discounted the possibility of earning better cashflow through an investment.

For instance, if you invest in a dividend paying stock that yields greater than the interest rate on your debt (after tax) that is cashflow positive versus paying down the debt… and you have the possibility of capital gains as well.

Leverage can be a great investment tool if you use it wisely.

Disclosure: I have no consumer debt and I choose to carry my mortgage and invest in dividend paying common stocks rather than paying my mortgage off. To each their own – do your own due diligence.

Trent, I have to disagree with you here. Putting money in investments, stocks, bonds and real estate can better your cash flow quicker than paying off the debt. And you don’t have the risk, you would have as you are waiting to pay off debt.

Paying down most debts does not decrease your risk – paying OFF debts does. The bank does not care if you owe $1000 or $1,000,000 on your mortgage when they foreclose. The government doesn’t care if your student loans are $500 or $50,000 when they start garnishing your wages. The car dealership can repo your car for non-payment no matter how much you owe.

And cash flow’s not always all it’s cracked up to be anyways. I could cash in investments and pay off my student loan right now. The net effect on my monthly cash flow? $52. Meanwhile my loans sit on autopay at 1.75%, and my investments are getting about 7.4%.

I don’t think “cash flow” is the reason. If you can put that money in savings instead, it will all be available to you in an emergency, even if you haven’t yet finished paying off your debt.

A better reason is if you’re actually more motivated to save by paying off debt than by adding to savings. You definitely can’t get the money back to use if you suddenly want to make a dumb purchase. Plus some people are just more motivated by the freedom of debt reduction than by the freedom of savings growth.

The freedom you get from paying off the debt is good. You can get that same freedom by having enough money in savings to pay off that debt at any time. Plus you have the additional freedom to do something else with that savings instead.

Saving the monthly payments in a liquid savings account (or in a mattress, or whatever) is the very lowest level of risk, but it comes at a cost. The same thing is true for paying off low interest debt. It is going to be right for some people, and not for others. Plus, there are not-strictly-financial aspects to consider, such as the psychological impact of various scenarios, the non-bankrupt-ability of student loans, etc.

A better way to think about it might be to view your entire financial picture as your “portfolio”. You want some money in low risk options (E-fund, paying off debt, CDs, etc.) and some money in high risk options (stocks in your retirement accounts, rental real estate, etc.) and the balance between the two will vary on your age, comfort level, and opportunities.

This advice simplified is “Risk and letting your money work FOR you.” I actually disagree with the risk vs. reward calculation someone mentioned above. Risk is risk. If you wouldn’t borrow money to invest then you shouldn’t hold debt and invest instead. It’s essentially the same thing. For the student loan, sure you can put it in forbearance. For a little while. We recently had to explore this option. Guess how long the forbearance period was? Six months. Many people have been unemployed longer than six months. And student loan debt is one that is not bankrupt-able. The problem, to me, is less about the numbers and more about the mentality that it is reasonable to carry debt long term. It’s unwise. Risk is often not calculated into financial decisions adequately and people often overlook the reality that you can’t control life changes. Get close enough to losing everything. Trust me. It will change your mind.

People go on about student loan forbearance as if it is such a good thing. It is akin to mortgage products that let you pay less than the interest portion of your loan, or like skipping a credit card payment without the negative impact to your credit score. Also, you should know that if you have private loans, there’s no guarantee you’ll be approved for it. It is much more difficult than public loans.
The better comparison to be made here, and someone touched on how Trent purchased his Prius, is the difference between cash flow and cash in hand. If you had the money to pay $15,000 for a car but the dealer offered you 0% financing for 3 years, wouldn’t you consider the offer? Well, only if you were in a good place to take on a payment of $416 a month. And if you only had $16,000 in all your savings, maybe the hit to cash flow is worth it to know that you could handle another emergency from savings.

I have to point out that using all your free money to pay down your mortgage only helps when the mortgage is fully paid off. If you have an emergency in the 10 years or so in between, you have no liquid assets to cover it and may end up losing the asset you’ve been trying so hard to pay off. For low interest debts, it makes more sense to invest the money until you’re able to pay off the debt in one lump sum, not dump every penny in it until then. With a 3% debt, it should be easy to earn an equal return, and you’re not at risk if your income is suddenly cut, you have the emergency money there and accessible.

If it were me, and what I wanted to pay down next were the mortgage [& didn’t already have that money in hand], I’d use part of the remaining $1K toward that, and invest/save part. It doesn’t have to be an all or nothing decision about where your money goes. Otherwise, I agree with Joanna #15 that having cash available in the interim could be a life-saver.

Besides the concerns others have raised, I think with very low interest debt (e.g. 3%), there’s a good argument to be made for maxing tax-sheltered retirement savings accounts as a priority over paying down the debt. Once you lose the right to contribute your $16.5K to a 401K this year and/or to a (Roth) IRA this year, that tax-sheltering is gone forever. Obviously this needs to be calculated in terms of your overall circumstances, including time horizon (how long will it be before you access the tax-sheltered accounts), funding of an adequate EF, job security, health, and so forth, but as I say, I do think it’s plausibly a strategy as good or better than the one Trent advocates here.

Very well said Trent.
I always think “Full Debt Free” is the way to live life.
There will be many who will argue that instead of paying that low interest debt, we can invest and earn more money, however still I feel that the best ways is to get yourself OUT from all the liabilities that you have. Simply because majority of people are not disciplined enough to invest that money and earn more returns, they are going to spend it on STUFF they don’t NEED.

I am full debt free (nothing except my monthly bills) for last 6 months and I can tell you – I feel that I am free to make my choices now…and soon I am planning for a career change too… It gives immense peace of mind to not think about making any payments to anyone (other than of course electricity, water etc..)

I am with Joanna on this one. For a very long time I had been debt free and was able to sock away a 65% down payment on an apartment. I now have a mortgage payment for three years which is about 23% of my disposable income. It is scary! I am looking for ways to improve my cash flow. What is terrible is I was used to having an emergency fund of 6-12 months of living expenses and now I have only about 2 months worth of living expenses as my Emergency Fund. In the past, one month’s living expense was something like 2000 TL, now it is 3500 TL. So what Trent says also makes sense but, it is impossible for me to pay this off before end of 2013 and the best that I can do is to accumulate a healthy Emergency Fund and hold on to it until the mortgage is paid off in May 2014. I JUST HATE DEBT! Hopefully after 2014, I will not need any more debt. I already own one apartment free and clear and buying the second was only possible through a mortgage.

Here’s another disadvantage to paying down the student loan. If you are short of money you can’t borrow more money from that source. If instead you invest the money you have access to those funds if you are in trouble. So I wouldn’t be in a hurry to pay down low interest loans.

One of the big arguments against paying off low interest debt goes something like this: “Why would I pay off a 3.5% loan when I can earn 7% on my investments instead?” We’ve even already seen this argument a little further up in the comments on this very post.

I have one question for those who adhere to that logic: Why would the bank loan you money at 3.5% interest if they could instead earn that same 7% on their money?

The answer, of course, is “risk.” You don’t get to earn a higher return without taking on more risk. It’s a fundamental law of economics. Yet those who argue in favour of carrying the low-interest debt completely ignore the risk aspect. They state the question as though the risk levels were identical, and the truth is, they’re not.

You earn 7% by taking on a lot more risk than the bank did. If that were not the case, then the bank would simply cut you out of the equation and make those same investments you are, and earn the higher return for the same risk.

My only real complaint with this article is one that I see a lot in Trent’s writing. Paying off low interest debts to increase cash flow is a good solution for some people, but may not be for others. It really depends on priorities and goals. Trent talks a lot about priorities and goals, so probably doesn’t feel the need to mention it in every article. This, however, can lead to the assumption that he means that the process described in the article is best for everyone, which it obviously is not.

I’m surprised that in addition to the cash-flow argument Trent didn’t mention the idea that paying off a loan is a guaranteed investment, compared to most other investments which come with no such guarantee. He has mentioned it before, but completely left it out of this article.

I’ll use a couple of examples given by commenters.

Courtney20 (#9) – 1.75% loans vs 7.4% investment. In this case paying off the loan results in a guaranteed 1.75% return (reduction in interest paid) while investing the money instead returns 7.4%. Obviously the 7.4% isn’t guaranteed, while the 1.75% is. On the surface the choice comes down to risk tolerance. For anyone willing to take on the extra risk to get a gain of 5.65% return keeping the loan probably makes sense. This may not be true, however, if the loan holder is planning to make a purchase, rather than invest their extra income. In this situation the increased cash flow (once the loan is paid off) might be preferable (depending on the liquidity of the investment).

Johanna (#3) – Savings vs low interest loan. It seems that in this discussion a low interest loan is considered anything less than 3%. Lets say the choice is between a 3% loan or a 1% return on savings. The impact to cash-flow here is likely very minimal (depending on the time it takes to pay off the loan and the amount). Paying down the loan results in a guaranteed 3% return, while putting the money into savings provides a 1% return (that is not guaranteed). The biggest difference here is liquidity. Does the extra 2% return outweigh the liquidity that putting the money into savings provides? That depends on the individuals risk-tolerance.

I prefer the debt free approach. It fits in well with my priorities and goals. Others will find that other approaches better fit their priorities. I doubt that Trent meant his suggestion to be one size fits all, but maybe he needs to be more clear about that.

That happens to me sometimes, too. Sometimes it takes months for them to clear (or, at least, they don’t clear for a few days, and I finally stop checking, only to discover months later that sometime in the interim, they’ve cleared) In the meantime, it’s somewhat amusing that you’re addressing Trent directly in the comments. I wish you good luck with that strategy.

For what it’s worth, your comment #3 is dead-on in my opinion. I really wish PF bloggers wouldn’t write stuff in such absolute terms. This post could have been couched differently “For many people, one good reason to pay off their low-interest debts is to increase their cash flow…” which leaves open that for many other people, doing that is not the best solution.

For those who agree with Trent’s reasoning, what would you say to this argument: “The reason I went with a 30 year mortgage over a 15 year note is to increase my cash flow. I can afford to buy my house either way , but the more cash I have left over after paying my bills, the better. Also, that’s why I always pay the minimum on my credit card bill.”

#27 Matt – Your argument is exactly what I was going to post. If it’s all about cash flow, then why not take out a 50 year loan? It’s better for cash flow!

I agree with everyone else who said that it’s a complex decision and there’s not real easy answer.

For example, while we can afford payments on a 15 year mortgage, we actually DID get a 30 year mortgage, and yes, for cash flow. We pay extra now, but if something came up, having a lower “minimum payment” would be useful.

As far as paying extra to get rid of it (it’s at 5%) – we put 10% down. I have PMI. I am paying extra ONLY until we hit 20% and can cancel PMI. I figure I am saving the most interest by paying extra in the beginning. I am planning on increasing our investments once we get to 20%. This fits with our personal investment philosophy and horizon.

Jonathan – thanks for your comment. But, regarding your last sentence of discussing my example, my point was exactly about how the cash flow isn’t a great deal all the time.

If I paid off my loan out of my investment account (it’s a Vanguard balanced mutual fund), it would take me 87 months to replace that money with my newly acquired cash flow. That’s a HUGE opportunity cost in terms of time, and that’s close to what I would call ‘long term’ for investments – meaning that while the 7.4% isn’t guaranteed, I certainly expect to average close to that amount over the 87 months.

Courtney20, sorry for the confusion. My comment was not based on the idea of trying to replace the balance in an investment. I was looking at the example in terms of starting out with a loan balance, and some amount of extra monthly income. One could start an investment with that extra income, or use it to pay down the loan. If the goal is maximizing investments, then the investment is probably a good plan. If the goal is maximizing cash flow, then paying down the debt may be better. Of course if the goal is to do both, then that complicates the decision (which I think is more along the lines of what you mentioned).

Trent’s advice is on-target. It is easy to discuss returns vs paydown – when you have income. When income stops then risk vs reward goes out the window and survival kicks in.
Cash is king, and the less of it you must give to someone else the better.
If anyone doubts the importance of cash flow… look to the airlines. American Airlines is on target to reach $10 billion in loses since 2001, losing quarters outnumber profitable quarters by about 3 to 1 and have there been any profitable years? Cash flow keeps American and all the other airlines afloat. Some analysts even estimate that the entire airline industry has never had a profitable year since they started in the 1930s. Cash Flow.

Dan — none of us argues that it’s better to have no debts/payments, however, Trent’s blanket advice does NOT apply to every situation.

For instance, for a family struggling to make ends meet, increasing cash flow makes a huge difference and yes, paying down debts is a good strategy that reduces risk. But what about families that don’t have trouble paying their bills and have a comfortable surplus every month? There is a real diminishing return on paying down low-interest debt when the payments are not a burden on the monthly budget. With a large monthly cushion built in, I would argue that the risk of “something happening” are low enough that I wouldn’t worry. Investing now really does pay off later.

Besides, call me crazy but when finances are in good shape I really do believe it’s ok to do something like . . . I don’t know . . . actually spend some of that income on living for today.

Once again, Trent has taken what works for him and spun it into an article about how everybody else should do the same things. His lack of insight into other priorities can be very astonishing.

It’s sometimes useful to have a savings account “paired” to an loan, for greater flexibility in paying it off.

If you’re worried about cash flow, for instance, and cash flow won’t increase until you pay *off* an installment loan (and not just pay it down), you can pay extra money into a savings account *as if* you were doing accelerated debt payments. At some point, the savings balance will equal the debt balance, and you can retire the loan all at once, giving yourself the extra cash flow you desire. If all has gone well, and the loan was low interest, this will happen about the same time that you would have retired the loan if you’d instead made extra loan payments.

But if you reach a cash flow crisis *before* you get that far, you can use the saved money to get you through the crisis (including by using it to make loan payments), as earlier commenters point out.

If, on the other hand, you’re secure in your finances, you can do the same trick in reverse. For the last car we bought, we opened a HELOC from which we paid part of the cost, and we paired it with a savings account we already had. We then paid off nearly all the loan with what was in the savings account. But for our own accounting purposes, we treated it as an installment loan, with the “payments” mostly going into rebuilding the savings account. (Our HELOC was quite liquid– you could put in or take out money at any time– and was not likely to go away given its size and the LTV of the house, so our risk for this strategy was low.)

We saved a bunch in interest costs doing it that way, while still paying off the loan and rebuilding our savings in a timely fashion.

This article follows my life’s strategy to a T!! My cash flow is allowing me to work less hours and spend more time in trying to establish an online presence so I can make a modest living. Thanxs for the inspiration Trent!!

Commenters 27/28 – I believe that’s the exact opposite of what Trent is trying to say.
(Upon re-reading and seeing this linked on Lifehacker, I realize how clumsily this article was handled)
He’s talking about removing obligations from your life and improving your FUTURE cash flow, and the liberty you have when you pay down debts. He’s talking about bringing your payoff closer rather than pushing it out. Essentially, you give up flexibility in the present for greater flexibility in the future.

Is it right for everyone? No, it is a personal thing, based on your own financial neuro-economics, but if he equivocated too much his writing would suffer.

He wasn’t explicit, but I believe the target audience of this strategy is people with extra money that they COULD throw towards their debt, but don’t because it is low interest. At least once a week someone writes in the mailbag, ” I have this debt, this savings account, and this much extra money at the end of the month, what do I do?” Paying down debts early (regardless of how small the interest) is going to be better for your net worth and future flexibility. Saving the cash now and investing means you’re below your means and increasingly prepared for an unforeseen calamity.

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